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Tuesday, 18 June 2013

Investment Valuation Ratios

The Investment Valuation Ratios compare a company current share price against its performance.or profitability. The seven Investment Valuation Ratios that will be discussed are:

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

1) Price / Book Ratio

The Price / Book ratio, or P/B ratio, is used to compare a company's current market price to its book value. It is an indication of how much shareholders are paying for the net assets of a company. Book value is how much a company is worth after all liabilities have been paid, it is an estimation of the value of a company if it were to be liquidated. This ratio provides investors a mean to compare what they are paying for each share (the market value), to a conservative measure of the value of the company.

Formula : Price / Book Ratio = Stock Price per share / Shareholders' Equity per share 

Benchmark : As with most ratios, it varies a fair amount by industry. Industries that are capital-intensive will usually trade at P/B ratios much lower than that of non-capital-intensive industries. P/B ratio of less than 1, then the company is selling below its book value and could represent an attractive buying opportunity at a bargain price, provided that the company's positive fundamentals are still in place.

Note : A higher P/B ratio implies that investors expect management to create more value from a given set of assets while a lower P/B ratio can means two things. The first scenario is that the stock is being unfairly undervalued by investor and could represent a bargain buy. The second scenario is that the market valuation of the company is correct and that something is fundamentally wrong with the company. 

Calculation : The Price / Book Ratio for Cisco as at 28 Jul 2012 is 15.69 / (51,286/5,340) = 1.63. The current market price of Cisco is $24.35 (14/6/2013) and the P/B ratio is 2.54. This means that Cisco's stock is trading at 2.54 times its book value currently.

2) Price / Cash Flow Ratio

The Price / Cash Flow Ratio  or P/CF, is a ratio used to compare a company's market value to its cash flow. It is used by investors to evaluate the investment attractiveness of a company's stock. The price / cash flow ratio is seen by many as a more reliable basis to evaluate the acceptability of a stock's current price. In contrast to earnings, sales and book value, companies have a much harder time manipulating cash flow. While sales, and inevitably earnings, can be manipulated through such practices as aggressive accounting, and book value of assets falls victim to subjective estimates and depreciation methods, cash flow is simply cash flow.

Formula : Price / Cash Flow Ratio = Stock Price per share / Operating Cash Flow per share 

Benchmark :  The lower a price / cash flow ratio is, the better value that stock is. According to Investopedia: "A high P/CF ratio indicated that the specific firm is trading at a high price but is not generating enough cash flows to support the multiple - sometimes this is OK, depending on the firm, industry, and its specific operations. Smaller price ratios are generally preferred, as they may reveal a firm generating ample cash flows that are not yet properly considered in the current share price. Holding all factors constant, from an investment perspective, a smaller P/CF is preferred over a larger multiple."

Note : Accounting laws on depreciation vary across jurisdictions, by using cash flow, the effects of depreciation and other non-cash factors are removed. Therefore, the price / cash-flow ratio can allow investors to assess foreign companies from the same industry (ex. mining industry) with a bit more ease.

Calculation : The Price / Cash Flow Ratio for Cisco as at 28 Jul 2012 is 15.69 / (11,491/5,340) = 7.29. The current market price of Cisco is $24.35 (14/6/2013) and the P/CF ratio is 11.32. 

3) Price / Earnings Ratio

Price / Earnings Ratio is defined as market price per share divided by annual earnings per share. It gives an idea of what the market is willing to pay for the company’s earnings. A high P/E ratio suggests that investors are expecting higher earnings growth in the future and has bid up the price. Conversely, a low P/E may indicate a “vote of no confidence” by the market. Value investors read a high P/E as an overpriced stock and a low P/E as a sleeper that the market has overlooked. Companies that are losing money do not have a P/E ratio.

Formula : Price / Earnings Ratio = Stock Price per share / Earnings per share 

Benchmark :  Historically, the average P/E ratio for the broad market has been around 15. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. While evaluating prospective stock, it is worthwhile to look at the current P/E ratio for the overall market (S&P500), the company's  industry segment and those of direct competitor company to determine if the prospective stock is in the high, low or moderate range . 

Note : It is important that investors avoid basing a investment decision on this ratio alone. The earnings are based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Calculation : The Price / Earnings Ratio for Cisco as at 28 Jul 2012 is 15.69 / (8,041/5,340) = 10.42. The current market price of Cisco is $24.35 (14/6/2013) and the P/E ratio is 16.17. 

4) Price / Earnings to Growth Ratio

Price/Earnings Growth ratio is calculated by dividing the P/E by the projected earnings growth rate. The PEG ratio is a refinement of the P/E ratio and factors in a stock's projected earnings growth into its current valuation. It is considered to provide a more complete picture than the P/E ratio.

Formula : Price / Earnings to Growth Ratio = P/E Ratio / Earnings per share Growth
The EPS growth can be obtained from Yahoo Finance under Analyst Estimates, or you can estimate your own growth rate.

Benchmark :  The PEG ratio of 1 represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth. If the PEG ratio is less than 1, the stock's price is undervalued, If it is more than 1, the stock is overvalued. Companies with PEG values between 0 to 1 may provide higher returns. The PEG Ratio can also be a negative number, for example, when earnings are expected to decline.This may be a bad signal, but not necessarily so. Under many circumstances a company will not grow earnings while its free cash flow improves substantially.

Note : The PEG ratio's when used with low-growth companies is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market). The PEG ratio is another way to try and identify undervalued high growth stocks through a technical screen. It should not be used alone to select stocks, and should instead be complemented with a fundamental analysis of the market and company to value the stock properly.

Calculation : The Price / Earnings Growth Ratio for Cisco as at 28 Jul 2012 is 10.42 / 8.33 = 1.25. The current market price of Cisco is $24.35 (14/6/2013) and the PEG ratio is 1.94. 

5) Price / Sales ratio

The Price / Sales Ratio or PSR, measures how many times investors are paying for every dollar of a company's sales. It is use to determine if the market is under or over valuing a stock’s price. Many investor consider a company sales figure a more reliable source than earnings in calculating a stock price multiple.

Formula : Price / Sales Ratio = Stock Price per share / Revenue per share 

Benchmark :  Generally speaking, a company trading at a PSR of less than 1 should attract your attention.  Most value investors set their PSR hurdle at 2 and below when looking for undervalued situations. But, as always, you need to compare a company's PSR value to its competitors and its own history. It is important that you only use the PSR to compare companies in the same industry since there will be differences among industry groups.

Note : Investors should exercise caution when using PSR since the numerator, the price of equity, takes a company's leverage into account, whereas the denominator, sales, does not. Comparing PSR carries the implicit assumption that all companies in the comparison have an identical capital structure. This is always a problematic assumption, but even more so when the assumption is made between industries, since industries often have vastly different typical capital structures (for example, a utility vs. a technology company). This is the reason why PSR across industries vary widely.

Calculation : The Price / Sales Ratio for Cisco as at 28 Jul 2012 is 15.69 / (46,061/5,340) = 1.85. The current market price of Cisco is $24.35 (14/6/2013) and the P/E ratio is 2.82.

6) Dividend Yield

The Dividend Yield or the dividend-price ratio of a share is the company's total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage. Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year.

Income investors value a dividend-paying stock, while growth investors have little interest in dividends. Not all stocks pay dividends, nor should they. If a company is growing quickly and can best benefit shareholders by reinvesting its earnings in the business, that's what it should do.

Formula : Dividend Yield = Annual Dividend per share / Stock Price per share 

Benchmark :  Ideally, dividend yield should be higher than the yield of any benchmark average such as the ten-year US Treasury note. Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield can be considered to be evidence that a stock is under priced or that the company has fallen on hard times and future dividends will not be as high as previous ones. Similarly a low dividend yield can be considered evidence that the stock is overpriced or that future dividends might be higher.

Note : When you're searching for stocks with high dividend yields, one quick check you should always make is to look at the company's payout ratio. It tells you what percentage of earnings management is doling out to shareholders in the form of dividends. If the number is above 75% consider it a red flag -- it might mean the company is failing to reinvest enough of its profits in the business. A high payout ratio often means the company's earnings are faltering or that it is trying to entice investors who find little else to get excited about.

Calculation : The Dividend Yield for Cisco as at 28 Jul 2012 is (1,501/5430) / 15.69 = 1.79%. The current market price of Cisco is $24.35 (14/6/2013) and the Dividend Yield is 1.15%.

7) Enterprise Value Multiple 

Enterprise value multiple is the comparison of enterprise value and earnings before interest, taxes, depreciation and amortization. This is a very commonly used metric for estimating the business valuations. It compares the value of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses. This measurement allows investors to assess a company on the same basis as that of an acquirer.

Formula : EVM = Enterprise Value / EBITDA
Where Enterprise Value = Market Capitalization + Debt + Minority Interest + Preferred Stock - Cash or Cash Equivalent.

Benchmark : A low ratio indicates that a company might be undervalued. Keep in mind that enterprise multiples can vary depending on the industry. Therefore, it's important to compare the multiple to other companies or to the industry in general. Expect higher enterprise multiples in high growth industries (like biotech) and lower multiples in industries with slow growth (like railways).

Note : The Enterprise value multiple will not be affected by this change in capital structure. This means that Enterprise value multiple cannot be manipulated by the changes in capital structure. Therefore, it makes possible fair comparison of companies with different capital structures.

Calculation : The Enterprise Value Multiple for Cisco as at 28 Jul 2012 is ((15.69x5340) + (31+16297) + 15 - 9799) / 10,755 = 8.39. The current market price of Cisco is $24.35 (14/6/2013) and the Dividend Yield is 12.70.

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